'Bad Bank' Regains Favor As Solution for Toxic Debt

Analysts say both Wall Street and Washington are largely resolved to creating a government-run entity to buy troubled assets from banks and other struggling financial institutions. It's just a matter of how and when—and some say, the sooner the better.

"Get on with the process of putting a value on these assets and lifting them off the banks' balance sheets," says Robert Glauber, who supervised the Treasury Department's role in the rescue of the savings and loan industry, which included a version of the bad bank concept, the Resolution Trust Corporation.

"No one wants to put money into these banks and see it become worth less,” he adds. “That has happened quarter after quarter."

Momentum for the so-called aggregate bad bank asset-purchase plan has built quickly since Fed Chairman Ben Benrnake mentioned the idea in a wide-ranging speech last week.

FDIC Chairwoman Sheila Bair referred on Wednesday to the financial-aid options Bernanke outlined, telling CNBC the aggregate bad bank option "might have an advantage in the sense that it actually moves the assets off the balance sheets, freeing up lending capacity."

Though some have scoffed at the resurfacing of the troubled asset purchase plan—which was the cornerstone of the TARP bailout package last fall. It was shelved by then-Treasury Secretary Paulson, who instead adopted a capital-injection model. Analysts say the continuing financial crisis underscores the concept’s utility and might even make it more attractive than before.

"They're [bank stocks] destroying the national wealth and they are dragging down the stock market," says Thomas Cooley, dean of NYU's Stern School of Business. "If the the financial system isn't provided the tools for commerce, the value of all firms declines. It's been like massive organ failure."

Cooley says that in this context, the interests of taxpayers and shareholders are converging. What's more, the policy choices have narrowed.

"The two options left are buying the assets or putting more capital in [the banks], and that is defacto nationalization," says veteran money manager Jim Awad, managing director at Zeyphr Management, explaining an emerging view.

The banking industry knows that—and so does the Obama administration, say analysts. And nationalization is a last resort in a time of insolvency.

"I don't think we want to function with the government owning the financial sector," says Glauber. "We can own a minority piece, and that may be necessary in the short term."

Of course, capital injections into dozens of banks have already brought that, and the government's return on investment has been miserable, much like that of the average investor.

Experts say the Obama economic team has been aware of the potential need for more aid to the financial system since shortly after the November election. At the time, Paulson made it clear he was communicating and consulting with the incoming Obama team, which included Treasury Secretary-designate Tim Geither, then-President of the New York Federal Reserve Bank.

Moreover, the President-elect made his concerns and priorities clear when he asked the Bush administration to seek release of the remaining TARP funds on his behalf, saying it would be "irresponsible" not to have "potential ammunition."

Geithner, when asked about the idea in his Senate confirmation hearing Wednesday, was naturally guarded, but said it is "possible” a bad bank” concept “will be part of the solution going forward."

Though there's no plan per se yet, the concept has broad industry support.

Jeff Immelt, chairman and CEO of General Electric (CNBC's parent company) Friday became the latest hig-profile executive to back the bad bank model, calling it a "good idea", and added "this is going to happen". New CitigroupChairman Richard Parsons has urged the government to create such an entity, citing the effectiveness of the RTC during the S&L crisis.

"We welcome the notion of going back to the original purpose [of the TARP plan]," says Steve O'Connor, senior VP for government affairs at the Mortgage Bankers Association. "Size and scale is an issue that is open to obvious debate."

So will the controversial issue of pricing the troubled asset. That dominated—and, some say, doomed—the original idea of a reverse auction run by the government.

Critics, Alternatives And Adversity

Critics say it remains a bad idea, no matter what the name.

“The central reason TARP didn't get off the ground is pricing,” says independent banking analyst Bert Ely, who also says comparisons to the savings-and-loan model are inappropriate.

“It becomes politically controversial. If the price is seen as too high then it’s a taxpayer give away. On the other hand, if prices are seen as too low, banks won’t sell, saying they can't take a hit.”

Ely says the government has already executed a preferable alternative in providing financial aid to major banks such as Citigroupand Bank of America.

Most recently the Treasury and FDIC agreed to “provide protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans” at Bank of America.

Terms of the agreement provide multi-year guarantees with the government prepared to cover losses and essentially separates these assets from the rest of those at the bank but keeps them on the books.

“It’s a very good template,” says Ely, usable on a bank-by-bank basis, and doesn’t involve the large bureaucracy that would come with the bad bank entity.

Bair has acknowledged the merits of insurance/guarantee concept, but her comments suggest she favors the off-the-books model, as do a majority of those interviewed for this story.

Banks clearly do, and in the current environment analysts say they we be more willing to take less money on the dollar for their bad assets than last fall, not that they’ll be giving anything away.

At the same time, Congress—which felt burned by Paulson’s change in strategy—will want assurances, if not guarantees, that the government will get a better deal than in the past, and thus avoid more complaints from constituents. The new President will also have to sell the idea to taxpayers.

"He [Obama] will have to say this is going to be aggravating, expensive and painful but we have to do it," says Cooley of NYU. "Without it the whole stimulus plan won't amount to much unless the financial markets start functioning again."

In that context, virtually all agree swift quick action is needed, saying a plan needs to be unveiled in the next couple weeks, and could happen as soon as the end of next week.